What does diversification mean for a diversified equity fund? Does it mean it will diversify across sectors and scrips, or across market capitalisation of stocks?

Outlook Money looked at equity funds to check out how little scheme objectives can tell you about the way they are going to invest.

To keep things simple, we checked out only diversified equity funds. We omitted thematic, sectoral and dividend yield funds. We also left out closed-end funds and equity-linked savings schemes since they usually have a higher allocation towards mid-cap scrips on account of a lock-in period.

Then we examined the portfolios of shortlisted funds across five time periods since July 2005 when mid-cap scrips were ruling the market.

Mutual fund schemes that call themselves 'diversified' had an unusually high proportion of their assets in mid-cap scrips. In all of them (top five mid-cap exposure schemes), the average mid-cap exposure was 61 per cent.

Gunning for the flavour. As diversified equity funds have a mandate to go anywhere, some of them usually skew their portfolios towards scrips and sectors that are the flavour of the month. For instance, during the technology sector boom in 2000, many diversified equity funds had invested significant portions of their portfolios in technology sector scrips.

Unlike the 1999-2000 bull run, in which only technology and related sectors found favour, the current run-up in equity markets is more broad-based and encompassed several sectors.

Also, small- and medium-sized companies have revamped their operations and turned into profitable ventures. Since these companies have shown tremendous potential, they attracted foreign and local investors such as MFs. That saw their share prices zoom.

Since 1 January 2004, the CNX Midcap index has returned 30 per cent on a compounded annualised basis as against 28 per cent by the large-cap Nifty index.

Returns between these two indices was not comparable around a decade ago; now both are mentioned in the same breath.

During the same time, 17 mid-cap funds were launched as compared to just five before. Additionally, diversified equity funds tilted their portfolios towards mid-cap scrips to cash in on the boom.

Evolving markets and industry. Things were different in earlier days when diversified equity funds were launched mainly as large-cap oriented funds, though they didn't say so explicitly in their offer documents.

The reason was that mid-cap scrips gained prominence only during the past four years, when many of these companies restructured themselves. Years back, MFs avoided such companies as many of them were not too profitable and their shares suffered from low liquidity.

Only in the past four years, such companies have grown in stature and size, thanks to a growing economy and acceptance of 'Made In India' products.

Companies like Hero Honda, Infosys [Get Quote] and Bharti Airtel [Get Quote], which were once mid-caps, are today names to reckon with and are considered as large-cap, blue-chip companies.

The investment universe for MFs has grown bigger. Even, say, 10 years ago, a modest number of companies across market capitalisation attracted a fund manager's attention.

Most of it went to large-cap companies. Today, established mid-cap scrips, partly because of their growth potential, get as much eyeball from equity funds as their large-cap counterparts.

Mid- and small-cap companies in their initial years generally stay below the fund managers' radar. But, when discovered, bring in bigger gains than established companies. So, diversified equity funds, and not just mid-cap funds, are scouring the market for potential multibaggers among mid-cap scrips.

Unchanged definitions. Unfortunately, diversified equity funds still harp in their offer documents on diversification that largely revolves around the number of scrips and sectors, but keep mum on market cap.

Technically, a fund is said to be diversified even if it invests around 60-80 per cent of its corpus in mid-cap scrips as long as it is has a sizeable number of scrips and sectors.

So are MFs wrong? Theoretically, they are not. MFs are bound by their offer documents and can stretch as much as these allow them to. Most diversified equity funds phrase their objective in a way that makes it mandatory for them to diversify across sectors and scrips, but rarely talk about market cap of potential investments.

Most MFs don't think that it's a problem. "Sebi mandates MFs to abide by their offer documents and treat them as the Bible. So, as long as the offer document gives the leeway to the scheme, irrespective of whether the objective is loosely or tightly defined, it's okay for schemes to skew their portfolios towards mid-caps," says T. P. Raman, managing director, Sundaram BNP Paribas MF.

Adds Krishnamurthy Vijayan, CEO, JP Morgan MF: "If a diversified equity fund goes heavy into mid-caps, you can't fault it. In spirit though, it won't be advisable." Sources say that if a fund manager has expertise in picking up stocks from a particular domain, his trustees may give him a larger leeway to play around in that domain, across all his funds.

Silent regulation. Sebi guidelines say that MFs must invest at least 65 per cent of their corpus in assets in tune with their objectives. This means an equity fund and a debt fund must invest at least 65 per cent of its assets in equities and debt, respectively.

It is silent on other aspects in diversification. Internationally, the US MF regulator, Securities and Exchange Commission, also doesn't specify the market cap limit that diversified equity funds must work within.

Says Sanjay Prakash, CEO, HSBC MF: "One fund manager's large-cap can be another manager's mid-cap." Prakash, though, feels that a standardised and flexible definition of various market caps would do well.

What should you do? There isn't a simple answer to this. For mid-cap funds, it's easier to look into the offer document as to what construes mid-cap scrips according to the fund.

Or, say, a large-cap fund that explicitly says so, like Franklin India Bluechip and SBI [Get Quote] Bluechip Funds. Or even some flexi-cap, multi-cap or 'opportunity' funds that claim in their offer documents to be 'go-anywhere' schemes.

But if it's a diversified equity fund, there's little assurance that your fund manager would keep largely to large-caps and not sway into mid- and small-caps, especially in rising markets.

It's only when equity markets turn volatile or start going down that diversified equity funds' tilt towards mid-caps would suffer.

Stick with MFs that come with a long-term track record and watch for consistent performance. A higher mid-cap skew will increase the risk the scheme carries. So, while upside is good, but the downside will hurt too.